This PDF is a selection from an out-of-print volume from the National Bureau of Economic Research

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1 This PDF is a selection from an out-of-print volume from the National Bureau of Economic Research Volume Title: Business Cycles, Inflation, and Forecasting, 2nd edition Volume Author/Editor: Geoffrey H. Moore Volume Publisher: Ballinger Volume ISBN: Volume URL: Publication Date: 1983 Chapter Title: Sequential Signals of Recession and Recovery Chapter Author: Victor Zarnowitz, Geoffrey H. Moore Chapter URL: Chapter pages in book: (p. 23-6)

2 I Chapter 4 Sequential Signals of Recession and Recovery Victor Zarnowitz* arid Geoffrey H. Moore Early and confirming signals of business cycle peaks and troughs are produced sequentially on a current basis by a system of monitoring smoothed rates of change in the composite indexes of leading and coincident indicators. Evidence is offered that the system would have identified each of the peaks and troughs of U. S. business cycles since 1949 without undue delays and false alarms. Countercyclical policies activated and deactivated by such signals would have desirable timing properties. COUNTERCYCLICAL POLICY TRIGGERS: THE PROBLEM AND ITS SETTING This chapter describes a sequential procedure for identifying the beginning and ending dates of business cycle recessions as promptly and accurately as practicable. Its origin lies in a study undertaken for The research underlying this chapter was supported by a grant to the Center for International Business Cycle Research from the Economic Development Administration. The EDA bears no responsibility for the content. Earlier versions were presented at the annual meeting of the American Economic Association in Denver on September 5, 198, and at the annual meeting of the Illinois Economic Association in Chicago on October 31, 198. We are indebted to Steven McNees, John Myers, and David Woolford for helpful comments, and to Chantal Dubrin and J. Rao for efficient research assistance. (Journal of Business, 1982, vol. 55, no. 1) by The University of Chicago. All rights reserved /82f551--4$1.5 *University of Chicago and National Bureau of Economic Research. 23

3 24 Business Cycles the Economic Development Administration (EDA), U. S. Department of Commerce, which deals with the problem of designing and testing an efficient trigger formula for public works expenditures with the aid of a system of cyclical indicators. However, the proposed approach can be applied much more broadly to any temporary countercyclical policy program on the national level. Federal policy programs of job creation through public works or public service employment have been repeatedly called countercyclical without in fact being so. Most such programs came into effect much too late to counter the cyclical rises in the national unemployment rate (which, of course, does not necessarily preclude their being appropriate for other reasons, e.g., because of relatively high levels of unemployment in the intended impact areas). In fact, public works programs were not enacted until nine to nineteen months after the cyclical decline in output had been reversed and that in employment nearly completed.' For the public service employment programs, the legislative and administrative lags have been considerably shorter, but not sufficiently so to produce significant countercycical effects.2 Moreover, no provision was made in any of the programs for effective cutoff dates related to signals of the progress of the recovery. In sum, the overall lags involved were such that the funds, instead of being spent to combat unemployment during recesssions, were actually spent when the expansion of the national economy was already well under way. The tardiness of policies designed to stimulate employment not only reduces their intended stabilizing (antirecession) effects but also induces some unintended destabilizing effects. Government expenditures are likely to contribute more to excess demand and inflationary pressures during a business expansion than during a business contraction. Ill-timed fiscal and monetary policies can, of course, have similar effects, The success of any discretionary countercyclical policy action depends critically on its timeliness; in addition, it must also have a sufficient degree of flexibility. However, the accuracy of economic forecasts tends to deteriorate as the forecast span lengthens and is generally not adequate for predictions looking as far ahead as a year or more. But shorter predictions of slowdowns and recessions, based on the actual record of cyclical indicators with early timing characteristics rather than on forecasts of such series, can be shown to provide useful first-alert signals which, when combined with confirmatory signals from measures of aggregate economic activity, are capable of producing a timely and reliable "triggering" mechanism. The main problem with recent public works programs as well as other policies intended to be countercycical lies in the long lags with

4 Sequential Signals of Recession and Recovery 25 which they are initiated and terminated. Most of the total delay is accounted for by the recognition, legislative, and administrative lags which would be eliminated if the programs were effectively triggered at the onset and at the end of a recession.3 As noted, the time between the allocation of funds and the employment of half the workers to be employed is approximately six to twelve months, which is not unduly long, given the duration of high unemployment created by recent recessions. The solution, then, lies primarily in making the policy action timely by tying it to certain prespecified indicator values which reliably signal the beginning and end of a recession. The required flexibility can be obtained by advance preparation of a backlog of useful projects to be mobilized progressively according to schedules related to a sequence of increasingly reliable signals.4 This study relates only to the problem of optimal timing of public employment policies in the context of cyclical movements in the U. S. economy as a whole. It is recognized that the effectiveness of the programs depends also on their size, financing, organization, and still other factors (such as any displacement and spilover effects), but these matters lie outside the scope of the present chapter. The plan of the procedure consists in identifying certain signals from suitably smoothed rates of change in composite indexes of cyclical indicators, which normally occur in a predetermined sequence. The possibility of false alarms is reduced by using turning points first in the leading and then in the confirming indicators. Actions based upon the initial turning points should be of a limited and reversible nature, involving relatively small commitments of funds. When the initial points have been confirmed by the subsequent turning points, more definitive and substantial actions should be taken. The signals devised in this plan refer directly to business cycles as defined and dated by NBER, but they also make use of the concept of growth cycles, that is, alternating periods of above-average and below-average rates of growth in aggregate economic activity. Since a growth slowdown preceded each recent recession, signals of the former give some advance warning of business cycle peaks. At troughs, leads of this type are typically fewer and much shorter, but if the signals are somewhat late they are also less scattered and often easier to read. In what follows, the rationale of the proposed strategy for using the cyclical indicators is outlined; the concept of the growth cycle and its relationship to the business cycle is explained; the procedures used and the results obtained thus far are presented and assessed; and some perspective is provided on the needs and the promise of further work.

5 26 Business Cycles CONCEPTS AND PROCEDURES The proper objective of countercyclical policy programs is to reduce the number of cyclically unemployed at times of overall slowdowns and recessions. This might seem to indicate that the policies should be initiated (discontinued) when the national unemployment rate rises above (falls below) some specified "high" level for some sufficiently long time. Indeed, triggering formulas based on unemployment statistics have received much attention in recent programs of direct employment stimulation by fiscal means. But here, as elsewhere, policy targets should not be confused with policy indicators. While the behavior of total unemployment is strongly influenced by business cycles, it is very difficult to separate the cyclical component of unemployment from the other components frictional, structural, and institutional. The use of high-unemployment trigger formulas will inevitably cause the programs to be badly mistimed, that is, to lag behind recessions and be active during expansions when unemployment may be relatively high for reasons other than cyclical dedines or deficiencies in aggregate demand. An analysis of a variety of labor market indicators shows that they are strongly affeéted by cyclical changes in the economy, but also that most of them are either too sluggish or too irregular in their timing to produce useful signals for our present purposes. However, one promising option is being explored in another study. This consists of combining several leading and trendless labor turnover series.5 The best of the options for a trigger formula, as currently considered, is a plan based on a comprehensive coverage of leading and confirming indicators of business expansions and contractions. There is ample evidence from a long series of studies that important and persistent timing sequences exist among series in each of the areas viewed as critical in business cycle theories. The following tabulation illustrates this in a general and selective way.6 Some of the main factors in Evidence from time series for business cycle theories: the corresponding variables: 1. Interaction between in- Large cyclical movements in vestment and final demand, business investment commitor between the investment ments (order, contracts) lead and savings functions, total output and employment; smaller movements in investment expenditures coincide or lag.

6 2. Changes in the supply of money, bank credit, interest rates, and the burden of private debt. 3. Changes in price/cost relations, in the diffusion, margins, and totals of profits, and in business expectations. Sequential Signals of Recession and Recovery 27 Money and credit flows (rates of change) are highly sensitive, with typically early cyclical timing; market interest rates coincide or lag. The profit variables all show large and unusually early cyclical movements, and so do stock price indexes. Unit labor costs contribute to this result by rising rapidly prior to and just after a business peak and falling prior to and just after a trough. More specifically, series that represent early stages of production and investment processes (new orders for durable goods, housing starts, or permits) lead series that represent late stages (finished output, investment expenditures). Under uncertainty, less binding decisions are taken first. For example, hours of work are lengthened (shortened) before the work force is altered by new hirings (layoffs). Other timing sequences reflect important stock-flow relationships involving the demand for and supply of output of goods and services, as influenced by changes in business fixed capital and inventories, money and credit. For well-supported theoretical reasons, a selected group of mdicators representing a whole set of these relationships has much greater predictive value over time than any of the individual indicators.7 This insight led to the construction of composite indexes of leading, coincident, and lagging indicators which indeed, as anile, outperform the individual Indicatprs. These indexes incorporate series that represent different economic processes but have similar cyclical timing. The best indicators from each economic-process group are selected by means pf a detailed scoring procedure incorporating several major criteria (economic significance, statistical adequacy, consistency of timing and conformity to the cyclical movements of the economy at large, smoothness, and currency). For each timing category (say, the leading series), the chosen indicators are combined into an index with weights provided by their overall performance scores.8 Our procedure uses the data from the leading and coincident composite indexes published by the U.S. Department of Commerce in Business Conditions Digest (BCD) each month. Cyclical peaks in the leading index often occurred early in the low-growth phases and an-

7 28 Business Cycles ticipated the beginning dates of recessions by variable but, on the average, rather long intervals, whereas the troughs in the index led the beginning dates of recoveries by quite short intervals. Reliable signals from the indexes proper, when we take into account the need for some smoothing and confirmation, would occasionally be too tardy for the purpose on hand. To obtain more timely and dependable indications, we found it advisable to use rates of change in the composite indexes with the aid of simple smoothing and decision rules.9 One such rule that turned out to be effective is that of taking the ratio of the current month's index to the average of the twelve preceding months and expressing the resulting percentage change at a compound annual rate' This is a smoothed six-month rate, which involves the same loss of lead time as an ordinary six-month change (where the current month is compared with the single month's figure six months earlier). The two are affected in the same way by any special factors that pertain to the current month, but the ratio that uses the twelve-month centered moving average in the denominator is for this reason much less subject to erratic fluctuations than the ordinary rate of change over six-month moving periods.1' Each of the composite indexes published in BCD contains a "target trend" of 3.3 percent per year (.272 percent per month). The purpose is to make the long-run trend in each index the same and equal to the trend rate of growth in the economy as a whole from 1948 to 1975, so that any differences in the behavior of the indexes are due to short-run factors.'2 Accordingly, the average value of the annualized rate-of-change series derived from the indexes over a long period is in each case approximately 3.3 percent. Thus, when the six-month smoothed rates of change described in the preceding paragraph are less than 33 percent, this means that the underlying index is rising at less than its long-term average rate. In the case of the leading index, this is an indication that a declining phase of the growth cycle is approaching; in the case of the coincident index, that it is probably under way. Likewise, when the annual rates of change come to exceed 3.3 percent, this means that an upswing in the growth cycle may be starting. Growth cycles represent an important but not very familiar phenomenon which may require some additional explanation. They are movements in aggregate economic activity defined by the consensus of fluctuations in comprehensive indicators adjusted for their longterm trends. They are thus composed of specific cycles in the deviations from trend of time series representing output, income, trade, employment, and many other economic processes, and they differ -,--.-.

8 Sequential Signals of Recession and Recovery 29 from business cycles in that the latter are defined by the consensus of fluctuations in the levels of the same collection of comprehensive economic indicators (see Chapter 5). A business cycle always involves at least one growth cycle, since in a contraction the short-term growth rate, being negative, is necessarily less than the long-term growth rate (which for an expanding economy is, of course, always positive reflecting the growth of total resources and their productivity). A business cycle will involve more than one growth cycle on those occasions when its expansion contains one or more protracted low-growth phases (periods when the short-term growth rate, while remaining positive, falls below the trend rate for a year or so).'3 Consequently, there are some "extra" growth cycles in addition to those which stand in a one-to-one correspondence with business cycles. Since 1945 the U.S. economy has passed through seven recessions the latest in the first half of 198 and it has also witnessed three periods of below-average growth rate that did not encompass recessions. Each of the seven expansions of the period decelerated before peaking and ending in a contraction; in other words, each of the recessions was preceded by a phase of positive but belownormal economic growth. The lags of business cycle peaks behind the starting dates of the low-growth phases lengthened substantially over this period, from two to six months for the first four of the peaks, which occurred in , to eight to thirteen months for the last three, which have occurred since This development reflects several interrelated trends in an economy with an expanding government, intensified inflation, increasing role of services versus goods in natidnal employment, and reduced rates of private investment and productivity. Whereas the growth cycle peaks led the business cycle peaks, the growth cycle troughs (marking the transition from low- to highgrowth phases) usually occurred at about the same time as the business cycle troughs. Occasionally, as in 1954, a growth cycle trough would follow a business cycle trough, that is, the recovery would start slowly, with the overall growth rate not getting up to the average level until some months later. The NBER reference chronologies for growth cycles and business cycles, on which the above statements are based, are presented in the first two columns of Tables 4-1 and 4-2 for the peaks and troughs, respectively. These lists of dates have been established by a close examination of time series of levels and deviations from trend for a broad set of comprehensive indicators of real economic activity.'4 It should he noted that the expansions of recent business cycles varied

9 4; Table 4 1. Three Signals of Recession: Timing at Business Cycle Peaks. Growth. Business Cycle Cycle Peak Peak First Signal (L < 3.3; Second Signal (L < ; Third Signal (L K ; Lead ( ) or Lag (+), in Months, at Business Cycle Peaks First Second Third > ) C < 3.3) C < ) Signal Signal Signal 7/48 11/48 N.A. N.A. N.A. 3/51 None 2/51 7/51 3/53 7/53 6/53 8/53 9/ /57 8/57 12/55 1/57 8/ /6 4/6 8/59 5/6 8/ /62 None 5/62 6/66 None 6/66 2/67 3/69 12/69 6/69 11/69 1/ /73 11/73 7/73 12/73 2/ /78 1/8 7/78 6/79 1/ Average Note: For full definitions of signals, see text. The following are regarded as false signals of a business cycle peak in constructing this table. First signal: a decline in the leading index rate below 3.3 percent in July Second signal: a decline in the coincident index rate below 3.3 percent in May September October November 1959, and April Third signal: a decline in the coincident index rate below zero in July 1956 and October-November r C

10 Table 4-2. Three Signals of Recovery: Timing at Business Cycle Troughs. Growth Cycle Business Cycle First Signal (L > ; Second Signal (L > 3.3; Third Signal (L > 3.3; Lead ( ) or Lag (+), in Months, at Business Cycle Troughs First Second Third Trough Trough C < ) C > ) C > 3.3) Signal Signal Signal 1/49 1/49 8/49 1/5 3/ /54 5/54 5/54 11/54 12/ /58 4/58 5/58 9/58 11/ /61 2/61 2/61 6/61 8/ /7 11/7 11/7 4/71 11/ /75 3/75 6/75 9/75 11/ /8 7/8 9/8 12/8 2/ Average Nole: For full definitions of signals, see text. -o i. C,, -4' Ce C) Cb Ce Ce -4 (4.)

11 32 Business Cycles greatly in length but averaged about fifty months, that is, about 4.5 times the mean duration of the contractions. In contrast, the growth cycles that emerge after elimination of the secular upward trend are nearly symmetrical, with high- and low-growth phases averaging twenty and eighteen months. Such regularities are attractive to business-conditions analysts and increasingly recognized. Certainly, it is much easier to recognize a developing slowdown than to pinpoint the date of a future downturn, and this strong presumption is well supported by lessons from recent forecasts. Since most low-growth periods do end as recessions, the concept and measurement of growth cycles can help provide some advance warning of business cycle peaks. Even though a slowdown may not evolve into a recession, its recognition gives time for precautionary action. Similarly, it is more important to stop antirecession action when a rapid recovery is under way than when a recovery is proceeding slowly. THE RESULTS: A SIGNALING SYSTEM AND ITS EX-POST RECORD The cyclical movements in the leading index tend to occur earlier than those in the coincident index. Figure 4-1 shows, in a hypothetical diagram, the smoothed rates of growth in the two series, which for simplicity will be called the "leading index rate" (L) and the "coincident index rate" (C))5 Among the earliest signs that an ongoing expaniion may start to decelerate is a decline in the leading index rate. This development is more decisively indicated when a sustamed decline of the growth rate in the leading index puts it below the average 3.3 percent line. A similar decline in the coincident index rate, which would normally occur later, confirms the onset of a general slowdown (low-growth phase) and suggests an increased possibility of a business cycle recession. If the leading index rate then falls below zero and the coincident index rate falls below 3.3 percent (not necessarily in this order), the probability of recession is heightened. Finally, if the coincident index rate follows the leading index rate by turning negative, chances are high indeed that the slowdown is being succeeded by an actual decline in overall economic activity, that is, a recession. The expected sequence of signals at business cycle peaks, then, is when each of the following conditions is first observed: First signal (P1): The leading index rate falls below 3.3 percent, while the coincident index rate is positive (L < 3.3; C> ). - --

12 Figure 4 1. Sequential Signals of Recession and Recovery: A Schematic Diagram. PERCENT (ANNUAL RATE) o PEAK o SIGNALS TIME X TROUGH X SIGNALS

13 34 Bus/ness Cycles Second signal (P2): The leading index rate becomes negative, and the coincident index rate falls below 3.3 percent (L < ; C < 3.3). Third signal (P3): Both the leading index rate and the coincident rate become negative (L < ; C < ). In Figure 4 1, the vertical links between the two curves remind us that these signals involve prespecified positions or changes in both index rates. The business cycle peak is expected to occur in the vicinity of P3, that is, no more than a few months earlier or later than that signal. This system of signals would have identified each of the six business cycle peaks from 1953 to 198 (we do not have sufficient data available to check the 1948 peak). The average lead at business cycle peaks was nearly ten months for the first signal, two months for the second signal. The third signal lagged the peak by an average of one month. As shown in Table 4-1, the variation of the individual leads or lags around these averages was considerable, with long advance warnings before the 1957 and 198 peaks, very short leads and lags in 1953, and intermediate situations in the remaining cases. However, sizable leads prevailed for the first signal, and even the third signal involved no long lags. It is important, too, that the sequence of the signals was maintained in each of the episodes covered. The first two signals also identified two of the three growth cycle slowdowns that did not become business cycle recessions (the first signal alone identified all three), but the third signal ruled out each of these instances. In addition, the system produced four "false warnings" that were not associated with either slowdowns or recessions, but none of these would have done real harm. Of these cases (listed in Table 4-1), two were single-month declines that related to the first or second signal only and were ruled out by the third. The other two were caused by the major steel strikes in 1956 and 1959 and would have been recognized as such at the time.'6 At the latest business cycle peak, which on June 3, 198 was identified by the NBER as January 198, the timing of the signals was as follows: first signal, July 1978, a lead of eighteen months; second signal, June 1979, a lead of seven months; and third signal, October 1979, a lead of three months. In this instance the third signal, where both the leading and coincident index six-month rates were negative for the first time, was interrupted in December 1979-January 198, when the coincident rate turned positive for two months. In February 198, it became

14 Sequential Signals of Recession and Recovery 35 negative again and remained negative through May. Hence the third signal either gave an advance warning three months before the January 198 peak or a delayed warning one month after the peak. In interpreting these results, one must allow for the fact that data are not available instantaneously. The indexes are published initially by the Commerce Department toward the end of the month following the month to which they refer. For example, the May indexes were released June 3. Hence, in terms of availability, the dates in Table 4-1. should be placed at least one month later. At business cycle troughs, the signals we have selected are slightly different, occurring when each of the following conditions is first observed: First signal (Ti): The leading index rate rises above zero, while the coincident index rate is negative (L > ; C < ). This means that the first signal of a trough must follow the third signal of a peak. Second signal (T2): The leading index rate rises above 3.3 percent, and the coincident index rate rises above zero (L > 3.3; c > ). Third signal (T3): Both the leading index rate and the coincident index rate exceed 3.3 percent (L > 3.3; C > 3.3). These signals identified the end of each of the seven business cycle recessions between 1949 and 198, though with more of a lag than was true of the peak signals. The average timing of the three signals at the seven business cycle troughs is as follows: first signal, one month lag; second signal, five-month lag; and third signal, sevenmonth lag. The variation around these averages from one cycle to another is shown in Table 4 2. There were no false signals of recovery in any instance in which the preceding business cycle peak had already been identified by the three peak signals. The lags of the signals at troughs are acceptable because at the beginning of recovery the level of activity is low (unemployment is at its cyclical peak levels), so that a program of public works expenditures may still be appropriate if it is tapering off and is discontinued after a brief period. While the third signal lags at business cycle troughs by seven months on average, most of the cyclical expansion is yet to come. In fact, in none of the seven instances would aggregate economic activity as measured by the coincident index have regained its previous peak level by the time the third signal was reached.'7

15 36 Business Cycles Hence the seven -month lag means that recovery is well under way and not likely to be aborted but has not reached a point where capacity utilization has become a problem. Figure 4-2 displays the behavior of the six -month smoothed rates of change in the leading index and in the coincident index relative to the business cycle peak and trough dates. The crossings of the 3.3 percent trend line and of the zero baseline which underlie the signals of these dates as listed in Tables 4-1 and 4-2 are identified. This allows a visual assessment of the workings of the procedure. One way to evaluate the set of signals here is to count the number of months during business recessions when the signals would have operated in the appropriate way and likewise during business expansions. Table 4-3 does this for the third signal and shows that it operated in the correct direction nearly 85 percent of the time between 1949 and 198. The signal of recession was "on" for about 8.5 years, compared with a total of about five years accounted for by the six recessions covered (since 1953). The record shows that these errors were heavily concentrated at the beginning of expansions and (to a lesser extent) at the beginning of recessions. The recession signal was always "off" before the economy recovered to its previous peak level (see text and note 17). In terms of public works expenditures, these are the most tolerable types of error. A brief delay in turning them off at the beginning of an expansion means that they will be concentrated during a part of the business cycle when economic activity is most depressed and inflationary pressures are apt to be receding. This record is very different from the actual performance of public works expenditures in the past, where a major problem has been that they have been concentrated in periods of high activity rather than low. The set of signals described in this chapter should make possible a significant improvement on past performance in this respect. Another kind of test is to see how the system works on similar data for other countries. The leading and coincident indexes currently compiled by the Center for International Business Cycle Research for six other countries provide the means for such a test. It is not, however, possible to compare the signals with business cycle peaks and troughs, because most countries do not have such chronologies. However, chronologies of growth cycles have been established by the Center. For an initial test we have selected one period, , when every country experienced not only a slowdown but also a recession. The results can be briefly summarized. 1. In each of the six countries (Canada, the United Kingdom, West Germany, France, Italy, and Japan), the three signals of peaks S A G A 4-

16 Sequential Signals of Recession and Recovery 37 Figure 4 2. Six-Month Smoothed Rates of Change in the Leading Index and in the Coincident Index. (A, the leading index rate. B, the coincident index rate.)

17 a; Table 4-3. Countercyclical Record of the Third Signal. A. Business Cycle Recessions Months of Recession % of Total Business Cycle Peak Trough (1) (2) Third Signal Peak Trough (3) (4) Total (5) Third Signal Correct (6) Third Signal Incorrect at Beginning (7) at End (8) Third Signal Correct (9) Third Signal incorrect at Beginning (1) at End (11) 11/48 1/49 7/53 5/54 8/57 4/58 4/6 2/61 12/69 11/7 11/73 3/75 1/8 7/8 Total n.a. n.a. 9/53 12/54 8/57 11/58 8/6 8/61 1/7 11/71 2/74 11/75 1/79 2/ f

18 B. Business Cycle Expansions Months of Expansion % of Total Business Cycle Trough Peak (1) (2) Third Signal Trough Peak (3) (4) Third Signal Incorrect Third Signal at at Total Correct Beginning End (5) (6) (7) (8) Third Signal Correct (9) Third Signal at Beginning (1) Incorrect at End (11) 1/49 7/53 5/54 8/57 4/58 4/6 2/61 12/69 11/7 11/73 3/75 1/8 3/5 9/53 12/54 8/57 11/58 8/6 8/61 1/7 11/71 2/74 11/75 1/ Total C. Business Cycle Recessions and Expansions Cots. 5 Cols. 6 Cola. 7 Cola. 8 Cola. 9 Cols. 1 Cols. 11 Total Note: Column 5 is the interval between the dates in columns 1 and 2. Column 6 is the interval between the dates in columns 3 and 2. Column 7 is the interval between the dates in columns 1 and 3. Column 8 is the interval (if any) from the date in column 4 to that in column 2. The false signals in 1956 and 1959 listed in the note to Table 4 1, which were associated with strikes, are ignored in this table. 5Exluding C,) -4'.

19 4 Business Cycles occurred in the expected sequence during , and the three signals of troughs did likewise during At the growth cycle peak in each country, the lag of the first signal, averaged across the six countries, was two months, while the second and third signals lagged by an average of five and six months, respecti.vely. At the growth cycle trough, the average lags for the six countries were zero, six, and eight months, respectively. 3. The system produced no false signals in any country during , but in Japan the third signal of a trough was subject to unusual delay. In this set of indexes, the "target-trend" growth rate for each country is equal to the rate of growth in its real GNP during For Japan, this is 7.8 percent per year. The coincident index rate did not reach that level until 1979 and then only briefly, even though a growth cycle trough was recognized in March Growth in Japan has, of course, slowed since the 1973 oil crisis. The growth cycle chronology allows for this change in trend, but the criterion used in the third signal does not. This points to one of the potential problems with the target-trend aspect of the signal system, although Japan was the only country where it had a significant effect. In general, the results of this test on data for other countries correspond well with those for the United States. At peaks the lags are longer than those shown for the United States in Table 4-1, but this is because growth cycle peaks (used in six countries) precede business cycle peaks. At troughs, where growth cycle and business cycle turns usually coincide, the lags for the six countries are nearly the same as those for the United States. As additional experience is gained, for example, in applying the system on a current basis, we shall be in a better position to appraise its virtues and limitations. MODIFYING THE SYSTEM FOR USE WITH CURRENT DATA An important limitation of the foregoing tests is that they use historical, not current, data. The index series are based on the best information available at the present time, that is, on figures which, for all but a few of the most recent months, have undergone several revisions. In actual practice, business analysts and forecasters cannot work with these data since they cannot afford the long delays entailed in waiting for the revisions to be completed. Realistically, the choice they have is restricted to using either the preliminary data, which involve the least delay but also are the least accurate, or the

20 Sequential Signals of Recession and Recovery 41 first revised data, which add another month to the lag of the indexes behind the events but improve the quality of the information.'8 Table 4-4 compares the monthly values of the leading index rate and the coincident index rate as they appeared in preliminary data and in first revised data. These series begin in October 1976 because consistent information of this type is not available for the earlier years.'9 The leading index rate based on preliminary data (Lv) dipped below the 3.3 percent level intermittently for a total of eight months between February 1977 and August These declines were generally short and shallow, but, under the strict application of the rules stated above, each of these months is associated with a false signal, identified in the table by the symbol (P1) (see columns 1 and 3). Only in November 1978 did the series L begin signaling the recession consistently, by falling and staying below 3.3 percent (and soon thereafter below percent). Accordingly, it is in that month that a true signal of the peak, denoted as P1, is shown in the table for the first time (the first appearance of a true signal is marked with an asterisk). The P1 signal was reported in each of the five following months. The coincident index rate based on preliminary data (Cr) declined below 3.3 percent in May 1979 and remained below that level until after the 198 recession, thus yielding (together with the leading index rate) a true second signal of the peak, P2 (see columns 2 and 3). However, C slipped intermittently below zero in four months between August 1979 and January 198, producing false third signals of the peak (P3). The true third signal, P3, is first dated March 198; it stayed on for six months, through August 198. When first revised data are used for the leading index rate (Lr) and the coincident index rate (Cr), the frequency of false signals is drastically reduced. The series Lr shows four months of false first signals (P1) between January 1977 and August 1978 (columns 5, 7). This compares with eight such months in the preliminary series L (see columns 3 and 7). According to the series Cr, the true second signal P2* occurred for the first time in April 1979 and stayed on for six consecutive months (columns 6, 7). When one allows for the longer information lag due to the revision, this timing is effectively the same as that of the preliminary series C (see columns 3 and 7). There are no false signals of the P2 type in either Cr or C1r,. Further, the use of Cr would result in fewer and less confusing false signals of the P3 type than use of C would. Finally, the revised data gave the third true signal of the peak, P3, for the first time in February 198 and

21 Table 4 4. Sequential Signals of Recession and Recovery, Two Variants, Applied to Preliminary and Revised Data, Preliminary Dala'1 First Revised Datab Year and Month Leading Index Rate (La) (1) Coincident Index Rate (Cr) (2) Signals of Business Signals of Business Cycle Turns Cycle Turns Level Band Signa1s' SignalsC (3) (4) Leading Index Rate (Lr) (5). Coincident Index Rate (Cr) (6) Level Band Signals c Signalsc (7) (8) October November December January (P1) February (P1) March April May June (P1) July (P1) August September October November December January (P1) February (P1) March (P1) (P1) April May June July (P1) (P1) August (P1) (P1) September October November P1* P1* P1* December P1 P P1 P1* P1 P1 P1 P1 P1 Cb C-) C)

22 L. December P January P1 P P1 P1 February P1 P P1 P1 March P1 P P1 P1 April P1 P P2* P2* May P2* P2* P2 P2 June P2 P P2 P2 July P2 P P2 P2 August September October November December 198. January February (P3) (P3) (P3) P2 P2 P2 P2 P2 -.9 (P3) P2.1 P P2 P2 (P3) (P3) (P3).8.4 P3* March P3* 3* P3 3* April P3 P P3 P3 May P3 P P3 P3 June P3 P P3 P3 July P3 P P3 P3 August P3 P P3 P3 September Ti* T1* Ti* Ti* October Ti Ti Ti Ti November T2* Ti Ti Ti December T2 T2* T2* T2* 1981 January T2 T T2 T2 February T2 T T3* T2 March T3* T T3 T3* April T3* T3* T3 T3 May (Pi)d T3 P2 P2 P2 P2 P2 P2 P2 a Based on the first published BCD figures (with a publication lag of one month). b Based on the second published BCD figures (with a publication lag of two months). cthe symbols are those used in the text, e.g., P1 denotes the first signal for peaks, T2 the second signal for troughs, etc. The false signals are in parentheses, e.g., (P1) or (T2), the true signals are not. The first time a true signal appears it is marked by an asterisk, e.g., Pi* or T2*. For the explanation of the systems of level signals and band signals, see text. dthe level of L in May i981 (2.7 percent) represents a first peak signal (Pi) which may or may not prove to be a false signal. Subsequent data as of September 198i show a P1 signal in June i981 and a P2 signal in August 1981, but no P3 signal.. (b C.') CO. (b

23 44 Business Cycles repeated it in each of the six ensuing months. This is again equivalent to the timing of the corresponding signal in the preliminary data (March-August 198). The NBER. designated January 198 as the business cycle peak on June 3, The trough of the 198 recession occurred in July 198, according to a recent finding by the NBER (July 8, 1981). Our first, second, and third trough signals are dated September and November 198 and March 1981, respectively, according to the preliminary data, and September and December 198 and February 1981 according to the revised data. The lags involved, two to nine months, are similar to those observed in recent recoveries (see Table 4 2 and text). Let us sum up the results obtained at this point: The simple device of using the first revised instead of the preliminary indexes turns out to be rather effective in dealing with the problem of false signals (as exemplified by the data relating to the January 198 peak). But another approach appears to work better still. It consists in redefining the signaling system by using bands of ± 1. percent around the critical levels of 3.3 percent and percent. This would approximately allow for the dispersion of the values of the random components of the composite indexes.2' Figure 4-3 shows how the "band approach" would work by means of a schematic diagram analogous to Figure 4-1 (which applies to the level approach used up to this point). Here the first signal of the peak, assuming the coincident index rate is above zero, occurs when the leading index rate declines across the band 3.3 percent ± 1. percent. If, after that happened, the leading rate rose again but stayed within the band (at points like A in Figure 4-3, for example), the signal would not be invalidated; for the signal to be revealed as false, the leading index rate would have to rise above the band (e.g., to point B). The second peak signal occurs when the leading rate falls below the band percent ± 1. percent, and the coincident rate falls below the band 3.3 percent ± 1. percent. The third peak signal is given when the coincident rate falls below the band percent ± 1. percent, while the leading rate remains below zero. The criterion defining false signals is everywhere the same: Backing up into the band does not invalidate the previous signal; reverse crossing through the band does. The expected sequence of signals at business cycle peaks, then, is when each of the following signals is first observed: First signal (P1): The leading index rate falls below 2.3 percent; the coincident index rate will usually be higher than 2.3 percent, but we require only that it be nonnegative (L < 2.3; C ).

24 Figure 4 3. PERCENT (ANNUAL RATE) Sequential Signals of Recession and Recovery: The Band Approach. TIME o PEAK X TROUGH o SIGNALS X SIGNALS CD Cd) :3 5) (5 :3 5) :3 (5 C)..' Cdl 3

25 46 Business Cycles Second signal (P2): The leading index rate falls below 1. percent and the coincident rate falls below 2.3 percent (L < -1.; C < 2.3). Third signal (P3): The coincident index rate falls below -1. percent, while the leading index rate is still negative (L < ; C < -1.). r At business cycle troughs, the first signal occurs when the leading index rate rises across the band percent ± 1. percent while the coincident rate remains below that band. If, thereafter, the leading rate falls back within the band (say, to point C), the signal continues to apply; if it falls below the band (say, to pointd), the signal is taken to be false. The second trough signal is given when the leading rate rises across the band 3.3 percent ± 1. percent and the coincident rate rises across the band percent ± 1. percent. The third signal occurs when both rates rise above the band 3.3 percent ± 1. percent. Again, the criterion for distinguishing false from true signals remains as defined above. To sum up, the expected sequence of signals at business cycle troughs is given by the first occurrence of the following: First signal (Ti): The leading index rate rises above 1. percent while the coincident index rate is less than 1. percent (L > 1.; C < i.).atimustfollowap3. Second signal (T2): The leading index rate rises above 4.3 percent and the coincident index rate rises above 1. percent (L > 4.3; C > 1.). Third signal (T3): Both the leading index rate and the coincident index rate rise above 4.3 percent (L > 4.3; C > 4.3). - To be reasonably successful, the band approach requires that (1) the proportions of observations that fall into the two bands be small for both index rates, L and C; and (2) the reverse crossings through the bands be very infrequent for both series. Unless the first condition applies, either L or C or both may meander within the bands, with the effect of delaying and perhaps obscuring the signals. Unless the second condition applies, false signals will present a problem. Fortunately, the evidence suggests that the two requirements are likely to be met by the data. As shown in Table 4-5, less than 7 percent of the observations for the leading index rate fell in the band 3.3 percent ± 1. percent and about 6 percent fell in the band percent ± 1. percent. For the coincident index rate, the corresponding

26 Class Interval (% Points) 4.4 and over and under Total Leading Index Rate (L) N (1) Sequential Signals of Recession and Recovery 47 Table 4-5. Frequency Distributions of Monthly Observations on Six. Month Smoothed Rates of Change in the Leading Index and in the Coincident Index, Frequency of Observations % (2) Coincident Index Ra te (C) N (3) % (4) Note: The measures in this table refer to the series plotted in Figure 4 2A (for L) and Figure 4-2B (for C). The series are based on the composite indexes published in U. S. Department of Commerce, Bureau of Economic Analysis, Business Conditions Digest (BDC) percentages are somewhat larger but still moderate: a little over 12 percent and 8 percent, respectively. Thus, the L series was outside of the two bands 87 percent of the time, and the C series was outside of the same bands 79 percent of the time. Returning to Table 4-4, let us inspect columns 4 and 8, which register the signals produced by the band approach for the preliminary and first revised data, respectively. There are no false signals at all in either set; that is, no reverse crossings of the bands occurred during this period of more than four years. This is a major advantage of using the band signals rather than level signals (cf. column 4 with 3, and column 8 with 7). There is no significant advantage to applying the band approach to the first revised data rather than the preliminary data (cf. columns 4 and 8). The timing of the band signals is in most cases identical with the timing of the corresponding level signals, as shown in Table 4-6. Hence this method, like the use of revised data, would cause no additional delay in the signals associated with the last recession and recovery. We conclude that the proposed procedure offers a promising way of dealing with the difficult and important problem of false signals on a current basis. It is somewhat surprising that the band signals do not show more of a lag relative to the level signals, since the two approaches differ in a way that would seem to suggest the presence of such lags (cf. Fig- 8.5

27 r Table 4 6. Timing of the Signals of Peaks and Troughs, Two Variants, Preliminary and First Revised Data, Preliminary Data First Revised Data Level Signals Band Signals Level Signals Band Signals Type Signal of Date (1) Lead ( ) orlag(+) (2) Date (3) Lead ( ) orlag(+) Date (4) (5) Lead ( ) orlag(+) (6) Date (7) Lead ( ) or Lag (+) (8) P1* Nov P2 3* May 1979 March Nov May 1979 March 198 Business Cycle Peak Signals 14 July April Feb Nov April 1979 March Business Cycle Trough Signals T1* T2* T3* Sept. 198 Nov. 198 March Sept. 198 Dec. 198 April Sept Dec Feb Sept. 198 Dec. 198 March Note: All leads and lags are in months. For the peak signals, they are measured from the NBER reference date for the business cycle peak: January 198. For the trough signals, they are measured from the NBER reference date of July 198 (see text and note 2). On the symbols for the types of peak and trough signals and the underlying data, see Table 4-4. C.)

28 Sequential Signals of Recession and Recovery 49 ures 4-1 and 4-2). As a last test available to us, we have therefore applied the band approach to the historical data extending back to The results are presented in Tables 4-7 and 4-8, which may be compared with Tables 4-1 and 4-2, respectively. The mean timing of the three band signals at business cycle peaks is -8, -3, arid +3 months, a slight overall delay relative to the corresponding measures for the level signals ( 1, -2, and +1). At troughs, the average leads or lags of the two sets of signals are virtually identical. It should also be noted that sequences of all three peak signals appear in Table 4-7 only in connection with business cycle recessions, not growth cycle slowdowns. The latter are associated either with first and second signals (as in 1951) or with the first signal only (as in 1962 and 1966). The absence of the P3 signal in each of these instances also rules out any trough signals in the years 1952, 1963, and In all these respects, there is a basic similarity between the band signals of Tables 4-7 and 4-8 and the level signals of Tables 4-1 and 4-2. The main difference is the absence of false signals, which constitutes a substantial advantage of the band approach. THE TIMING OFTHE SIGNALS AND INFLATION Ideally, countercyclical policies should be timed so as to also have some stabilizing effects on prices in general. If the price level increased in business expansions and decreased in business contractions, the two aims of policy, far from being in any way inconsistent, would actually be complementary. In the 194s and earlier, the comprehensive price indexes did tend to fluctuate with the business cycle. In the recent era of persistent inflation, the general level of prices of goods and services no longer shows any comparable degree of downward flexibility. Thus, as shown in Figure 4-4, the six-month smoothed rate of change in the consumer price index (to be called, for simplicity, the CPI rate) became negative in and , during and immediately after the first two business cycle contractions of the post World War II period; but it stayed positive during each of the five recessions that occurred in the following quarter-century. However, despite the upward trend in inflation since the mid- 196s, the CPI rate continued to show a cyclical pattern. The oniy significant declines in this (and other) measures of inflation occurred during recessions or, increasingly, in the early recovery phases (Figure 4-4). Inflation decelerated sharply on most of these occasions,